Credit Derivatives: Instruments, Applications, and Pricing MARK J.P. ANSON FRANK J. FABOZZI MOORAD CHOUDHRY REN-RAW CHEN John Wiley & Sons, Inc.

Credit Derivatives: Instruments, Applications, and Pricing MARK J.P. ANSON FRANK J. FABOZZI MOORAD CHOUDHRY REN-RAW CHEN John Wiley & Sons, Inc.

Credit Derivatives: Instruments, Applications, and Pricing

THE FRANK J. FABOZZI SERIES Fixed Income Securities, Second Edition by Frank J. Fabozzi Focus on Value: A Corporate and Investor Guide to Wealth Creation by James L. Grant and James A. Abate Handbook of Global Fixed Income Calculations by Dragomir Krgin Managing a Corporate Bond Portfolio by Leland E. Crabbe and Frank J. Fabozzi Real Options and Option-Embedded Securities by William T. Moore Capital Budgeting: Theory and Practice by Pamela P. Peterson and Frank J. Fabozzi The Exchange-Traded Funds Manual by Gary L. Gastineau Professional Perspectives on Fixed Income Portfolio Management, Volume 3 edited by Frank J. Fabozzi Investing in Emerging Fixed Income Markets edited by Frank J. Fabozzi and Efstathia Pilarinu Handbook of Alternative Assets by Mark J. P. Anson The Exchange-Traded Funds Manual by Gary L. Gastineau The Global Money Markets by Frank J. Fabozzi, Steven V. Mann, and Moorad Choudhry The Handbook of Financial Instruments edited by Frank J. Fabozzi Collateralized Debt Obligations: Structures and Analysis by Laurie S. Goodman and Frank J. Fabozzi Interest Rate, Term Structure, and Valuation Modeling edited by Frank J. Fabozzi Investment Performance Measurement by Bruce J. Feibel The Handbook of Equity Style Management edited by T. Daniel Coggin and Frank J. Fabozzi The Theory and Practice of Investment Management edited by Frank J. Fabozzi and Harry M. Markowitz Foundations of Economic Value Added: Second Edition by James L. Grant Financial Management and Analysis: Second Edition by Frank J. Fabozzi and Pamela P. Peterson Measuring and Controlling Interest Rate and Credit Risk: Second Edition by Frank J. Fabozzi, Steven V. Mann, and Moorad Choudhry Professional Perspectives on Fixed Income Portfolio Management, Volume 4 edited by Frank J. Fabozzi Handbook of European Fixed Income Securities edited by Frank J. Fabozzi and Moorad Choudhry

Credit Derivatives: Instruments, Applications, and Pricing MARK J.P. ANSON FRANK J. FABOZZI MOORAD CHOUDHRY REN-RAW CHEN John Wiley & Sons, Inc.

MJPA To my wife, Mary, and to my children, Madeleine and Marcus, for their enduring patience FJF To my sister, Lucy MC To Yves Gaillard, respect, and an inspiration to us all RRC To my wife, Hsing-Yao Copyright 2004 by Frank J. Fabozzi. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-750-4470, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008, e-mail: permcoordinator@wiley.com. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services, or technical support, please contact our Customer Care Department within the United States at 800-762-2974, outside the United States at 317-572-3993, or fax 317-572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley, visit our web site at www.wiley.com. ISBN: 0-471-46600-X Printed in the United States of America 10 9 8 7 6 5 4 3 2 1

Contents PREFACE ABOUT THE AUTHORS vii ix CHAPTER 1 Introduction 1 CHAPTER 2 Types of Credit Risk 23 CHAPTER 3 Credit Default Swaps 47 CHAPTER 4 Asset Swaps and the Credit Default Swap Basis 81 CHAPTER 5 Total Return Swaps 99 CHAPTER 6 Credit-Linked Notes 119 CHAPTER 7 Synthetic Collateralized Debt Obligation Structures 131 CHAPTER 8 Credit Risk Modeling: Structural Models 179 CHAPTER 9 Credit Risk Modeling: Reduced Form Models 201 CHAPTER 10 Pricing of Credit Default Swaps 223 v

vi Contents CHAPTER 11 Options and Forwards on Credit-Related Spread Products 255 CHAPTER 12 Accounting for Credit Derivatives 275 CHAPTER 13 Taxation of Credit Derivatives 299 INDEX 319

Preface The credit derivative market has grown from a few customized trades in the early 1990s to a large, organized market that trades billions of dollars each year. This market has expanded to reflect the growing demand from asset managers, corporations, insurance companies, fixed income trading desks, and other credit-sensitive users to buy and sell credit exposure. In this book we provide a comprehensive examination of the credit derivatives market. As the title of the book indicates, we cover the practical applications of credit derivatives as well as the most current pricing models applied by asset managers and traders. We also discuss investment strategies that may be applied using these tools. Our soup to nuts approach begins with an overview of credit risk. In many cases, credit is the predominant, if not overwhelming, economic exposure associated with a note, bond, or other fixed-income instrument. We discuss the nature of credit risk, discuss its economic impact, and provide graphical descriptions of its properties. We next discuss some of the basic building blocks in the credit derivative market: credit default swaps, asset swaps, and total return swaps. These chapters are descriptive in nature to introduce the reader to the credit derivatives market. The following chapters provide numerous examples of credit derivative applications. Specifically, we describe the credit-linked note market as well as synthetic collateralized debt obligations. Credit derivatives are used to provide the underlying credit exposure embedded within these fixed-income instruments. These chapters demonstrate how credit derivatives are efficient conduits of economic exposure that would otherwise be difficult to acquire in the cash markets. The next group of chapters provides the mechanics for the modeling and pricing of credit risk. These chapters are more quantitative in nature as is necessary to provide a thorough review of current credit pricing models. However, our goal is not to dazzle the reader with out knowledge of rigorous mathematics, but rather, to provide a comprehensive framework in which credit derivative contracts can be efficiently priced. vii

viii Preface Finally, we provide a discussion on the accounting and tax treatment of credit derivatives. Throughout the book, we provide numerous examples of credit derivatives, their practical applications, and where pricing information can be found through Bloomberg and other sources. Our ultimate goal is to provide the reader with a complete guide to credit derivatives, whether it be for reference purposes, day to day use, or strategy implementation. We would like to thank Abukar Ali of Bloomberg L.P. in London for his assistance with the chapter on credit-linked notes (Chapter 6) and help with Bloomberg screens. We benefited from insightful discussions regarding credit default swap pricing with Dominic O Kane of Lehman Brothers in London. The views, thoughts, and opinions expressed in this book represent those of the authors in their individual private capacity. They do not represent those of Mark Anson s employer, the California Public Employees Retirement System, nor KBC Financial Products (UK) Limited or KBC Bank N.V. or of Moorad Choudhry as an employee, representative or officer of KBC Financial Products (UK) Limited or KBC Bank N.V. Mark J.P. Anson Frank J. Fabozzi Moorad Choudhry Ren-Raw Chen

About the Authors Mark Anson is the Chief Investment Officer for the California Public Employees Retirement System (CalPERS). He has complete responsibility for all asset classes in which CalPERS invests. Dr. Anson earned his law degree from the Northwestern University School of Law in Chicago where he graduated as the Executive/Production Editor of the Law Review, and his Ph.D. and Masters in Finance from the Columbia University Graduate School of Business in New York City where he graduated with honors as Beta Gamma Sigma. Dr. Anson is a member of the New York and Illinois State Bar Associations. He has also earned the Chartered Financial Analyst, Certified Public Accountant, Certified Management Accountant, and Certified Internal Auditor degrees. Dr. Anson is the author of three other books on the financial markets and is the author of over 60 published articles. Frank J. Fabozzi, Ph.D., CFA, CPA is the Frederick Frank Adjunct Professor of Finance in the School of Management at Yale University. Prior to joining the Yale faculty, he was a Visiting Professor of Finance in the Sloan School at MIT. Professor Fabozzi is a Fellow of the International Center for Finance at Yale University and the editor of the Journal of Portfolio Management. He earned a doctorate in economics from the City University of New York in 1972. In 1994 he received an honorary doctorate of Humane Letters from Nova Southeastern University and in 2002 was inducted into the Fixed Income Analysts Society s Hall of Fame. Moorad Choudhry is Head of Treasury at KBC Financial Products (U.K.) Limited in London. He previously worked as a government bond trader and Treasury trader at ABN Amro Hoare Govett Limited and Hambros Bank Limited, and in structured finance services at JPMorgan Chase Bank. Mr. Choudhry is a Fellow of the Centre for Mathematical Trading and Finance, CASS Business School, and a Fellow of the Securities Institute. He is author of The Bond and Money Markets: Strategy, Trading, Analysis, and a member of the Education Advisory Board, ISMA Centre, University of Reading. Ren-Raw Chen is an associate professor at the Rutgers Business School of Rutgers, The State University of New Jersey. He received his doctoral ix

x About the Authors degree from the University of Illinois at Champaign-Urbana in 1990. Professor Chen is the author of Understanding and ManagingInterest Rate Risks and a coauthor of Managing Dual Risk Risks (in Chinese). He is an associate editor of the Review of Derivatives Research, Taiwan Academy of Management Journal, and Financial Analysis and Risk Management. Dr. Chen s articles have been published in numerous journals, including Review of Financial Studies, Journal of Financial and Quantitative Analysis, Journal of Futures Markets, Journal of Derivatives, Journal of Fixed Income, and Review of Derivatives Research.

CHAPTER 1 Introduction D erivatives are financial instruments designed to efficiently transfer some form of risk between two or more parties. Derivatives can be classified based on the form of risk that is being transferred: interest rate risk (interest rate derivatives), credit risk (credit derivatives), currency risk (foreign exchange derivatives), commodity price risk (commodity derivatives), and equity prices (equity derivatives). Our focus in this book is on credit derivatives, the newest entrant to the world of derivatives. Credit derivatives are financial instruments that are designed to transfer the credit exposure of an underlying asset or assets between two parties. With credit derivatives, an asset manager can either acquire or reduce credit risk exposure. Many asset managers have portfolios that are highly sensitive to changes in the credit spread between a default-free asset and credit-risky assets and credit derivatives are an efficient way to manage this exposure. Conversely, other asset managers may use credit derivatives to target specific credit exposures as a way to enhance portfolio returns. In each case, the ability to transfer credit risk and return provides a new tool for asset managers to improve performance. Moreover, as will be explained, corporate treasurers can use credit derivatives to transfer the risk associated with an increase in credit spreads. Credit derivatives include credit default swaps, asset swaps, total return swaps, credit-linked notes, credit spread options, and credit spread forwards. In addition, there are index-type products that are sponsored by banks that link the payoff to the investor to a specified credit exposure such as emerging or high yield markets. By far the most popular credit derivatives is the credit default swap. Credit default swaps include single-name credit default swaps and basket default swaps. Credit default swaps have a number of applications and are used extensively for flow trading of single reference name credit risks or, in 1

2 CREDIT DERIVATIVES: INSTRUMENTS, APPLICATIONS, AND PRICING portfolio swap form, for trading a basket of reference credits. Credit default swaps and credit-linked notes are used in structured credit products, in various combinations, and their flexibility has been behind the growth and wide application of the synthetic collateralized debt obligation and other credit hybrid products. Credit derivatives are grouped into funded and unfunded instruments. In a funded credit derivative, typified by a credit-linked note, the investor in the note is the credit protection seller and is making an upfront payment to the protection buyer when buying the note. In an unfunded credit derivative, typified by a credit default swap, the protection seller does not make an upfront payment to the protection buyer. In a funded credit derivative, the protection seller is in effect making the credit insurance payment upfront and must find the cash at the start of the transaction; whereas in an unfunded credit derivative the protection, payment is made on termination of the trade (if there is a credit event). Unlike the other types of derivatives, where there are both exchangetraded and over-the-counter (OTC) or dealer products, as of this writing credit derivatives are only OTC products. That is, they are individually negotiated financial contracts. As with other derivatives, they can take the form of options, swaps, and forwards. Futures products are exchangetraded and, as of this writing as well, there are no credit derivative futures contracts. Moreover, there are derivative-type payoffs that are embedded in debt instruments. Callable bonds, convertible bonds, dual currency bonds, and commodity-linked bonds are examples of bonds with embedded options. A callable bond has an embedded interest rate derivative, a convertible bond has an embedded equity derivative, a dual currency bond has an embedded foreign exchange derivative, and a commodity-linked bond has an embedded commodity derivative. Derivatives have made it possible to create many more debt instruments with complex derivative-type payoffs that may be sought by asset managers. These debt instruments are in the form of medium-term notes and referred to as structured products. Credit derivatives are also used to create debt instruments with structures whose payoffs are linked to or derived from the credit characteristics of a reference asset (reference obligation), an issuer (reference entity), or a basket of reference assets or entities. Credit-linked notes (CLNs) and synthetic collateralized debt obligations (CDOs) are the two most prominent examples. In fact, the fastest growing sector of the market is the synthetic CDO market. Credit derivatives are the key to the creation of synthetic CDOs.

Introduction 3 ROLE OF CREDIT DERIVATIVES IN FINANCIAL MARKETS In discussing the role of credit derivatives in the U.S. financial market, Alan Greenspan, Chairman of the Federal Reserve Board, in a speech in September 2002 stated: More generally, such instruments appear to have effectively spread losses from defaults by Enron, Global Crossing, Railtrack, World- Com, and Swissair in recent months from financial institutions with largely short-term leverage to insurance firms, pension funds, or others with diffuse long-term liabilities or no liabilities at all. In particular, the still relatively small but rapidly growing market in credit derivatives has to date functioned well, with payouts proceeding smoothly for the most part. Obviously, this market is still too new to have been tested in a widespread down-cycle for credit. But so far, so good. 1 There have been and continue to be mechanisms for protecting against credit risk but these mechanisms have been embedded within bond structures and loan agreements and not traded separately. Examples in bond structures are private mortgage insurance in residential mortgage-backed securities, insurance wraps provided by monoline insurance companies for municipal bonds and asset-backed securities, and letters of credit. The issuance of bonds backed by collateral in the structured finance market has required the transfer of assets. In the case of collateralized loan obligations, loans have to be transferred to a special purpose vehicle. This is a disadvantage for legal reasons in some countries the borrower must approve the assignment of a loan and business reasons potential impairment of banking client relationships. The growth of the market for synthetic CDOs is a testament to this desire not to transfer assets. Credit derivatives are a natural extension of the long-term trend of shifting credit risk from banks to nonbank investors who are willing to accept credit risk for the potential of an enhanced yield. Consider, for example, the public market for bonds. This debt instrument is simply a substitute for bank borrowing. In the United States, the typical publicly traded bond was one that at issuance had an investment-grade rating. Thus, credit risk of investment-grade corporate borrowers was shared by banks and nonbank investors via bond issuance. This is a relatively new economic phenomena in many non-u.s. countries where bond markets 1 World Finance and Risk Management, speech presented at Lancaster House, London, U.K., September 25, 2002.